The use of restricted stock awards to compensate employees is
growing in popularity in place of the much-maligned stock option. One
of the reasons for the shift to restricted stock is the reduced charge
against income provided by restricted stock awards as compared to
stock option grants. Restricted stock is also less dilutive to the
company’s stock than options, because value to the employee can be
achieved with fewer shares.

Executive
compensation practices came under increased congressional scrutiny
when abuses at corporations such as Enron became public. The
American Jobs Creation Act of 2004, P.L. 108-357, added Sec. 409A,
which accelerates income to employees who participate in certain
nonqualified deferred compensation plans (including stock option
plans). Later in 2004, FASB issued Statement no. 123(R),
Share-Based Payment, which requires expense treatment for
stock options for annual periods beginning in 2005. (Statement no.
123(R) is now incorporated in FASB Accounting Standards Codification
Topic 718, Compensation—Stock Compensation.) The median
number of stock options (per company) granted by Fortune 1000
firms declined by 40% between 2003 and 2005, and the median number
of restricted stock awards increased by nearly 41% over the same
period (“Expensing Rule Drives Stock Awards,” Compliance
Week, March 27, 2007). From 2004 through 2010, the number of
restricted stock holdings of all reporting executives in the S&P
500 increased by 88%.

With
the increased popularity of restricted stock, CPA tax practitioners
must be familiar with the rules governing taxation of restricted
stock awards when advising clients who have been or may be offered
restricted stock awards, as well as when advising corporations that
make the awards.

RISK OF FORFEITURE AND NONTRANSFERABILITY

Sec.
83 determines the income tax consequences to both the award’s
receiver (the employee) and its grantor (the employer). Under Sec.
83(a), property transferred to an employee as compensation for
services is taxable to the employee on the earlier of the date the
property is not subject to a substantial risk of forfeiture by the
employee or the date it is transferable by the employee.

Under
Regs. Sec. 1.83-3(c)(1), a substantial risk of forfeiture exists
where rights in the stock are conditioned, directly or indirectly,
upon the future performance (or refraining from performance) of
substantial services by the employee (commonly referred to as an
“earn-out” restriction), or the occurrence of a condition related to
a purpose of the transfer, and the possibility of forfeiture is
substantial if such condition is not satisfied. An example of a
condition related to the purpose of a transfer is a requirement that
the employee return the stock if the total earnings of the company
do not increase. One of the more common requirements is that the
employee remain with the company for a certain time. However, Regs.
Sec. 1.83-3(c)(2) indicates that a requirement that the stock be
returned upon the employee’s being discharged for cause or for
committing a crime will not be considered a substantial risk of
forfeiture. An enforceable requirement that the employee agree to a
covenant not to compete after leaving the company’s employ or the
employee’s agreeing to provide consulting services after retirement
will also not be considered a substantial risk of forfeiture unless
the particular facts and circumstances indicate otherwise.

Regs.
Sec. 1.83-3(c)(3) warns that a substantial risk of forfeiture will
not exist where employees own a substantial amount of the voting
stock or other classes of company stock, unless they can demonstrate
that they do not control the company and the possibility of the
company’s enforcing the forfeiture restriction is substantial. Also,
stock is not subject to a substantial risk of forfeiture to the
extent that the employer is required to pay the fair market value
(FMV) of the stock to the employee upon the return of the stock
(Regs. Sec. 1.83-3(c)(1)).

Under
Regs. Sec. 1.83-3(d), the stock is nontransferable if the employee
is prohibited from selling, assigning or pledging (as collateral for
a loan, as security for the performance of an obligation or for any
other purpose) his or her interest in the stock to any person.
Additionally, the stock will be considered nontransferable if the
transferee is subject to the forfeiture restrictions, even if the
employee is permitted to sell, assign or pledge the stock. An
example in Regs. Sec. 1.83-1(f) provides a safe harbor for the
employee: If evidence of the risk of forfeiture is stamped on each
stock certificate, the stock is considered nontransferable. The
regulations also provide that the stock will not be considered
transferable merely because the employee may designate a beneficiary
to receive the stock at death.

Consequently,
a restricted stock award will result in taxable income to the
employee under Sec. 83 in an amount equal to the excess of the
stock’s FMV on the date the restriction lapses, over the stock’s
sale price to the employee. The employee adjusts his or her original
basis in the stock by the income amount. The employer may claim a
deduction on the date the restriction lapses for the amount included
in the employee’s income.

In
situations where the employee purchases the employer’s stock with
monies borrowed from the employer, Regs. Sec. 1.83-4(c) requires the
employee to include in income any amount that is subsequently
canceled, forgiven or satisfied for an amount less than the
indebtedness, in the tax year in which the cancellation, forgiveness
or satisfaction occurs. Sec. 83(h) allows a deduction to the
employer in a similar amount.

ELECTION TO ACCELERATE INCOME INCLUSION

Sec.
83(b) allows the employee to accelerate the recognition of income by
electing to include the compensation portion of the restricted stock
(any excess of its FMV at the time of the transfer over the amount
paid for it, determined without regard to any restriction other than
a permanent restriction on its transferability) in gross income in
the year the award is received. The lapse of the restrictions is not
a taxable event if the employee makes the election. The election can
be beneficial to the employee, as any appreciation in stock value
between the date of the award and the date the restrictions lapse is
taxed only if and when the employee disposes of the stock.
Additionally, the employee’s holding period starts on the award
date, not when the restrictions lapse, so when the employee disposes
of the stock, the appreciation is taxed not at the ordinary income
tax rate but rather at the lower, long-term capital gain tax rate
(assuming it has been held for more than one year). Therefore, in
situations where the employee expects the stock price to increase
during the restricted period, he or she can expect to reduce tax
liability by the spread between his or her ordinary tax rate and the
long-term capital gain tax rate. However, the election can be
detrimental where the stock later declines in value or is forfeited.
See “Risks for the employee” below.

Regs.
Sec. 1.83-2(a) allows the election in situations where the employee
has paid full value for the stock, realizing no bargain element in
the transaction. In such cases the employee will recognize no income
on the date of the award and will avoid compensation income for
appreciation in the stock after the award.

The
Sec. 83(b) election may take on additional significance for
directors, officers and principal stockholders of the employer who
are subject to “short swing” trading profit liability under Section
16(b) of the Securities Exchange Act of 1934. Sec. 83(c)(3) provides
that this potential liability is a restriction as defined in Sec.
83(a). Therefore, the compensatory sale of stock to those covered by
the Section 16(b) liability could result in unanticipated
compensation income to the purchaser even where the stock appears to
be unrestricted (that is, there are no substantial risk of
forfeiture or nontransferability restrictions) in all other aspects.
Making the Sec. 83(b) election allows the individual to avoid
compensation income when the Section 16(b) restriction lapses.

Method
of making the election. Sec.
83(b)(2) stipulates that the Sec. 83(b) election must be made no
later than 30 days from the date of the transfer. Regs. Sec. 1.83-2
requires the employee to file the election in the form of a written
statement with the IRS office at which the employee regularly files
his or her tax returns and attach a copy to the return. The employee
must send a copy of the election to the employer; if the transferee
of the property is not the employee, the employee must provide a
copy of the election to the transferee. The statement’s required
information is specified in Regs. Sec. 1.83-2(e).

Revocability. Sec.
83(b)(2) also stipulates that the election is irrevocable without
the IRS’ consent. However, Rev. Proc. 2006-31 permits a revocation
if the employee files it on or before the due date for making the
election. Additionally, under Regs. Sec. 1.83-2(f), revocation will
be granted where the transferee is under a mistake of fact as to the
underlying transaction and the revocation is requested within 60
days of the date on which the mistake of fact first became known to
the person who made the election. Section 5, Example 3 of Rev. Proc.
2006-31 describes as an example of a mistake of fact a situation
where a different class of stock is transferred to an employee than
the class specified under an employment contract, where after making
the election, the employee discovers the transferred stock is of a
different class. However, a mistake about the value of the property
with respect to which the employee made the election, or a failure
to perform an act contemplated at the time of transfer of the
property does not constitute a mistake of fact. A mistake of fact
does not include a mistake of interpretation of law, including
misunderstanding the forfeiture rules or any other aspect of the
proper tax treatment of the transfer.

Risks
for the employee. The
election under Sec. 83(b) carries at least two risks to the
employee. One is that the property may not in fact appreciate but,
rather, depreciate during the restricted period. In such case, the
amount included in income when the employee made the election is not
now deductible. Also, the employee can take a loss deduction only
when he or she sells the stock, and the deduction will be subject to
capital loss limitation rules. Employees will find themselves in the
unenviable position of having reported ordinary income at the time
of the award and paid the requisite income tax, followed by a
capital loss upon its later disposition. Thus, if the employee is
uncertain as to the growth or decline in value of the stock
received, he or she might consider not making a Sec. 83(b) election.

A
second risk is that, under Sec. 83(b)(1), no deduction is allowed to
the employee if the stock is forfeited. Remember, as discussed
earlier, a misunderstanding of the forfeiture provisions is not
justification for revoking the election. However, Regs. Sec.
1.83-2(a) does permit a capital loss deduction for the excess paid
for forfeited stock above any amount realized upon the forfeiture,
including any amount of the purchase price restored by the employer
to the employee.

Regs.
Sec. 1.83-2(a) also warns that a sale or other disposition of the
property that is in substance a forfeiture or is made in
contemplation of a forfeiture shall be treated as a forfeiture.

The
risk of forfeiture was brought painfully to light in Kadillak
(127 T.C. 184 (2006), aff’d, 534 F.3d 1197 (9th Cir. 2008)). By
exercising incentive stock options granted to him by his employer,
Anthony Kadillak purchased company stock that was subject to the
restriction that the company could exercise the right to repurchase
the stock if his employment with the company terminated within four
years of the award. The company held the shares in escrow and would
transfer them to Kadillak as they vested over the four-year period.
Kadillak timely filed a Sec. 83(b) election for the shares. On his
tax return for the year of the award, Kadillak reported alternative
minimum taxable income (AMTI) of more than $4 million, of which
approximately $3.26 million represented the difference between the
value of the stock and its cost to him. About one year after the
award, Kadillak’s employment with the company was terminated, and
the company repurchased his nonvested shares at cost. Kadillak then
filed an amended return for the year of the award, claiming that
AMTI should not be recognized on the nonvested shares.

Before
the Tax Court, Kadillak argued the Sec. 83(b) election was invalid
because the company held the shares in escrow and they were not
legally transferred to him. The court, however, reasoned that,
because Kadillak held all shareholder rights in the nonvested stock,
including rights to dividends, he held the stock as the beneficial
owner; therefore, his Sec. 83(b) election was valid, and he owed tax
on the full $3.26 million AMTI, as reported on his original return.
Kadillak appealed to the Ninth Circuit, which affirmed the Tax
Court’s holding.

Corporate
deductibility. The
Sec. 83(b) election also affects the amount and timing of the
deduction permitted the corporation on its income tax return.
Generally, corporations granting restricted stock awards to
employees are permitted a tax deduction when the restrictions lapse.
However, where the employee has made a Sec. 83(b) election, the
corporation’s deduction is accelerated to the award date. In
situations where the stock price has increased during the
restriction period, the Sec. 83(b) election results in a lower
deduction for the corporation than if the Sec. 83(b) election had
not been made.

Restricted
stock units. Some
employers choose to issue restricted stock units (RSUs) to employees
rather than restricted stock, because employees cannot make a Sec.
83(b) election in connection with restricted stock units. RSUs are
unfunded promises to pay cash or stock to the employee based on a
vesting schedule. One RSU is typically equal in value to one share
of company stock. The company does not deliver the cash or shares of
stock until the vesting and forfeiture requirements have been
satisfied. RSU participants have no voting rights on the stock
during the vesting period, because they actually have not been
issued any stock. The rules of each plan determine whether RSU
holders receive dividend equivalents. Issuing RSUs allows the
employer (rather than the employee) to control the timing of the
compensation deduction and to have the possibility of a larger
deduction should the value of the employer’s stock increase during
the restricted period. Additionally, employers who issue RSUs do not
need to keep track of whether employees have made the Sec. 83(b) election.

HELPING CLIENTS MAKE AN INFORMED DECISION

It
is imperative that employees understand the tax consequences under
Secs. 83(a) and (b) so they can make an informed decision and not
get stuck with an unexpected tax liability. CPA tax practitioners
should advise their clients who have been or may be offered
restricted shares of the benefits and risks associated with a Sec.
83(b) election. The election will be beneficial to the client if the
client is confident that he or she will not forfeit the stock and
that the stock will appreciate in value during the restricted
period. On the other hand, the election will not benefit the client
if he or she forfeits the stock and/or the stock declines in value
after the election is made.

CPA
tax practitioners advising corporate clients issuing restricted
stock should point out that the amount and timing of the
compensation deduction on the corporate tax return for restricted
stock can be affected by the employees’ actions. The deduction could
be reduced if employees are permitted to make the Sec. 83(b)
election. Such a possibility does not exist, however, if the
corporation issues restricted stock units rather than restricted stock.

EXECUTIVE SUMMARY

While
compensatory stock options have fallen out of favor, use
of restricted stock awards has increased. The stock is not taxable
to the employee until either it is no longer subject to a
substantial risk of forfeiture by the employee or is transferrable
by the employee.

A
risk of forfeiture generally exists if
the employee must remain employed by the company, or the company’s
earnings hit specified targets and the employer is not obligated
to pay the stock’s fair market value (FMV) to the employee if it
is forfeited.

Employees
may elect instead under Sec. 83(b) to
include in gross income at the time of transfer the stock’s FMV
(without regard to any restriction other than a permanent
restriction on its transferability) above the amount they paid for
the stock. However, risks for employees include that no deduction
for a loss on disposition of the stock is generally allowed if the
stock is forfeited. The election may be revoked only under a few
circumstances including a “mistake of fact” concerning the
election.

CPAs
can help individual taxpayer clients make informed decisions
concerning restricted stock and
whether they should make a Sec. 83(b) election. Those who advise
corporate clients can provide guidance concerning the amount and
timing of a deduction for restricted stock compensation
paid.

Steven
T. Petra (actstp@hofstra.edu) is a
professor and director of graduate programs in taxation at
Hofstra University in Hempstead, N.Y. Nina T. Dorata (doratan@stjohns.edu) is an
associate professor at St. John’s University in New York
City.

To
comment on this article or to suggest an idea for another
article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or
919-402-4434.

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